Liability Under Section 10 and Rule 10b5

42. What is liability under “Section 10(b)” and “Rule 10(b)(5)” of the 1934 Act?

Section 10(b) prohibits fraud in connection with the purchase and sale of any security. This provision applies whether or not the security is registered under the ’34 Act. The SEC adopted Rule 10(b)(5) to implement section 10(b). Together, these anti-fraud provisions are the basis for most litigation under the ’34 Act. These provisions make it unlawful to use most communication methods (such as the mail, internet, or wire) or any national securities exchange to defraud any person in connection with the purchase or sale of any security. Any party directly connected to the sale of securities is potentially liable; though there may be limits on the liability of certain professionals, such as auditors, bankers, accountants, etc. Rule 10(b)(5) allows for a cause of action by the SEC as well as private actions. Generally, Rule 10(b)(5) prohibits the following conduct in connection with the sale of a security:

• using any device, scheme, or other artifice to defraud purchasers;

⁃ Example: A device or scheme includes any sales or investment program, whether done in person or via distant communication, to defraud participants.

• making any untrue statement or failing to disclose any material fact that make the statement misleading; or

⁃ Example: This includes making false statements or failing to disclose relevant information in the process of selling or transferring a security.

• employing any practice that would deceive or defraud.

⁃ Note: This is a very broad, catch-all provision. These prohibitions give rise to a potential cause of action for plaintiffs under Rule 10(b)(5), the elements of which are as follows:

• Deceit – A plaintiff must demonstrate deceit through the misrepresentation or omission of information. This must be done either intentionally or recklessly. Simple negligence is not enough to establish liability.

• Material Information – The information must be material to the purchaser of the security. That is, the information must be important to a potential investor in making the decision of whether or not to purchase the security. What is material information is interpreted very broadly and based on the individual situation of the company.

• Purchase of Sale of a Security – The information must directly related to the purchase or sale of a security. An individual who does not purchase or sell a security based upon the deceitful information cannot bring an action under this provision.

• Reliance on the Information – The actual purchaser must rely on the misrepresented information. Reliance is assumed if material information is omitted or broadly stated to the whole market.

• Cause Damages – The plaintiff must suffer some actual damages resulting from or caused by the omission or misrepresentation. This normally comes in the form of a diminution in the value of the shares purchased.

In summary, to recover under Rule 10(b)(5), a plaintiff, whether the SEC or a private plaintiff, must show that an individual trading in securities had an intent to deceive the purchaser. Intent to deceive may be inferred from a partial or untimely disclosure of important information.

• Discussion: How do you feel about the extensive liability or breadth of potential actions available under Section 10(b) or Rule 10(b)(5)? Do you think these provisions are overly broad? Why or why not?

• Practice Question: Bernie is the head of a new investment firm. His firm solicits money from investors and invests that money in short-term, high-risk securities. Bernie has been suffering substantial losses, but has been able to continue to pay investor returns from the funds invested by new investors. In order to attract new investors, he is falsifying much of the information on his investment returns. The DOJ gets word of his practices and begins an investigation. In the meantime, shareholders bring a civil action under Rule 10(b)(5) to recover their losses from Bernie. What elements will they have to demonstrate in Bernie’s conduct to find him liable?